Economic Commentary: An attack of PSBR schizophrenia

Click to follow
The Independent Online
I am suffering from advanced schizophrenia on the question of the gigantic budget deficit of around 9 per cent of national income that the Government will be running in 1993-94.

Half of me, scarred no doubt by the memory of working in the British government in the mid-1970s, is quite convinced that deficits of this size are the first step towards turning Britain into a banana republic.

But the other half, still heavily influenced by my Keynesian roots, is just as convinced that it would be pure folly to attempt to reduce the deficit at a time when recession could yet turn into slump. I really must sort myselves out.

The first step to a resolution is to recognise that the overwhelming force that has been shaping the large swings in the public sector borrowing requirement in the past decade has been equally large variations in the private sector's financial activities. In the mid-1980s the private sector suddenly developed an appetite for debt never previously seen.

As savings declined and borrowing surged, the economy enjoyed a period of unparalleled growth. This filled the Government's coffers and the public sector temporarily ran a large surplus.

This surplus had little or nothing to do with 'fiscally responsible' decisions by the Government. It was merely the automatic counterpart of the private sector's borrowing binge. Nevertheless, one of the many things that Margaret Thatcher successfully privatised was about half of the Government's mountain of outstanding debt.

It was just as well that the Exchequer allowed itself to be pushed into surplus in this way. If it had attempted to balance its books it could have cut taxes by much more than even Nigel Lawson and Mrs Thatcher ever dreamed.

ECONOMIC VOLCANO

For example, in 1989-90, the Government could have cut taxes by pounds 14bn - 7p off income tax - and still balanced the budget. But if it had chosen this course it would have turned a rampaging boom into something even more catastrophic. The top would have been blown off an already erupting economic volcano.

Precisely the opposite now applies. The private sector has become dissatisfied with the amount of debt it is holding and is curtailing its expenditure relative to income. In the resulting recession government revenue has fallen sharply and public expenditure on recession-related benefits has risen. Hence there has been a move back into budget deficit.

Again it is a blessing that this has been allowed to occur. If the Chancellor had sought to balance the budget this year he would have needed to increase taxation by almost pounds 40bn, which clearly would have resulted in the slump to end all slumps.

The implication of this is that the automatic stabilisers in the Government's budget have been playing their usual role in helping to dampen the economic cycle. This, indeed, has been by far the most important cause of the deterioration in government accounts in the past three years, with the recession probably explaining around two-thirds of the likely budget deficit in 1993-94.

In a sense, what has happened is that the private sector has decided that the switch from public to private sector debt in the 1980s went much too far. Consequently, individuals and companies are seeking to reduce their debt ratios by cutting spending. The automatic consequence has been an offloading of debt back to the public sector, which has so far been sensible enough to accept the situation without too much demur.

According to calculations in the Green Budget prepared by Goldman Sachs and the Institute for Fiscal Studies, the ratio of outstanding public debt to GDP is likely to rise from 40 per cent now to about 60 per cent by the end of this Parliament, assuming the economy enjoys a 'normal' recovery in the next four years.

On the face of it this looks alarming, but in fact it would simply take the debt ratio back to where it was in the early 1980s. Roughly speaking, the effects of the boom of the 1980s would have been cancelled out by the impact of the slump of the 1990s, taking government debt back to square one.

All of these factors greatly influenced the thinking of the Treasury's Independent Forecasting Panel, which strongly recommended in its first report to the Chancellor that there should be no attempt to rein back the government deficit by increasing taxes this year.

It is very clear that the main problem in the economy today is a shortage of demand, and it is equally clear that the budget deficit is mitigating this problem without yet leading to an intolerable build-up of public sector debt - or indeed to any financing problems in the gilt market.

Last week I visited more than a dozen

of America's largest international investing institutions and, while I encountered a good deal of concern about the UK's budget position, I met no one who thought that the Chancellor should actually tighten fiscal policy this year. Furthermore, many of them seemed willing to increase their exposure to the gilts market, despite the high PSBR.

Why, then, should the Chancellor feel any discomfort at all about the budget deficit? It is because, even in a recession, it is possible to run a deficit that is too large, in the sense that it can land the Government in the kind of 'debt trap' from which Italy is currently trying to escape. This happens when a high debt ratio is combined with high real interest rates, leading to explosive growth in government debt servicing costs.

SELF-FINANCING

In a fascinating section of his report to the Treasury panel, Wynne Godley argues that such a situation simply cannot arise in a demand-constrained economy. He says that in such circumstances a rise in public spending will always produce enough extra output to be self-financing.

Not only will sufficient extra revenue be produced to cover the costs of the ad

ditional public spending, but also enough to cover any extra debt servicing costs that arise during the transition.

I suspect, though, that this result is totally dependent on the specific assumptions made in the Godley model. In particular, it hinges on the way in which consumption is assumed by Mr Godley to be dependent on private wealth (which includes the stock of government bonds, and therefore rises as the budget deficit increases).

It is an unfortunate fact that, in economics, spectacular theorems of this sort almost always turn out to depend on a succession of highly specific assumptions that can crumble on close inspection.

Anyway, what does seem indisputable is that the Italian government is struggling with a debt trap today while its economy is quite clearly demand-constrained. Britain is a very long way from being in the same position, but another couple of years of slippage could change that.

Most of the acceptable leeway on the government accounts has now been used up. The implementation of tax increases this year is unnecessary and would be dangerous. But medium term policy should be set with at least one eye on the path for the PSBR.

The Clinton approach - a progressive programme of budget cuts pre-announced several years ahead and offset by easy monetary policy - would seem appropriate over here too.

Comments